Regulatory failure: banks offered incentive to buy government debt

CNBC carried an interesting article on how financial regulators are offering an incentive banks to buy government securities.  Regulators do this by waiving the need for banks to hold capital against these securities.

Of course, government debt is not risk free.  Not only is there interest rate risk, but as Iceland, Ireland and Greece have shown, there is also default risk.

Requiring banks to hold zero capital against assets with this type of risk profile is a fairly clear example of regulatory failure.

US and European regulators are essentially forcing banks to buy up their own government's debt—a move that could end up making the debt crisis even worse, a Citigroup analysis says. 

Regulators are allowing banks to escape counting their country's debt against capital requirements and loosening other rules to create a steady market for government bonds, the study says. 

While that helps governments issue more and more debt, the strategy could ultimately explode if the governments are unable to make the bond payments, leaving the banks with billions of toxic debt, says Citigroup strategist Hans Lorenzen. 

"Captive bank demand can buy time and can help keep domestic yields low," Lorenzen wrote in an analysis for clients. "However, the distortions that build up over time can sow the seeds of an even bigger crisis, if the time bought isn't used very prudently." 

"Specifically," Lorenzen adds, "having banks loaded up with domestic sovereign debt will only increase the domestic fallout if the sovereign ultimately reneges on its obligations." 

The banks, though, are caught in a "great repression" trap from which they cannot escape.
"When subjected to the mix of carrot and stick by policymakers...then everything else equal, we believe banks will keep buying," Lorenzen said....

"Ask the simple question: Why are banks buying sovereign debt when yields are either near record lows, or perhaps more interestingly, when foreign investors are pulling out?" Lorenzen wrote. 

He thinks he has the answer. 

For one, the European Central Bank's Long-Term Refinance Operations provided guarantees for the debt, which Lorenzen deems a "heavily sweetened form of financial repression given the pressure banks were under" to buy. 

"Banks have ended up buying bonds at yields where they would happily have sold them only a few months prior," he said. 

Moreover, banks are allowed to not count the sovereign debt against their Basel capital requirements. Also, Lorenzen argued, European banks have escaped the onus of stress tests this year, a less-than-subtle hint that authorities are willing to tolerate a bit of looseness in banks so long as they are helping to stave off a full-blown debt crisis. 

"One doesn’t have to be too cynical to hypothesize that all the disclosures on sovereign exposure have become a bit of a political liability at a point in time where the only buyers in size of periphery sovereign debt are periphery banks funded by the ECB," he said. 

"As long as funding for sovereigns in markets remains in jeopardy, and as long as there is no clear move towards proper fiscal solidarity in Europe, we reckon there will be a strong political incentive to make banks captive buyers. That implies a move away from marking sovereign debt to market, away from raising risk weights, away from capital ratios that don't risk weight assets and away from stress tests incorporating government bonds."